TOPIC 5 Flashcards
(12 cards)
Aggregate Supply (AS) and Aggregate Demand (AD) model
The goal is to
explain how the economy operates in the short and medium term, considering the goods and
services market, the money market, and the labor market.
We distinguish two types of equilibrium:
- Short-term equilibrium: the goods and money markets are in equilibrium, but there is a
mismatch in the labor market. - Medium-term equilibrium: all three markets are in equilibrium.
Additionally, we assume GDP = GNP = National Income = Y.
Behavior of Aggregate Demand
Aggregate Demand shows the total quantity that households are willing to consume at each price level.
The AD curve is derived from equilibrium conditions in both the goods and money markets (from the
IS-LM model) for different price levels.
Aggregate Demand is downward-sloping: There is a negative relationship between the price level
and the quantity demanded.
Shifts in Aggregate Demand in the Short Term
Since Aggregate Demand reflects both the goods market (IS curve) and the money market (LM curve),
any factor shifting IS or LM will also shift AD. Thus, AD can be shifted through fiscal and/or monetary
policies.
- Expansionary: Right
- Contractionary: Left
Additionally, changes in consumer confidence or expectations can also move AD.
Aggregate Supply
In the long term, aggregate output depends on the availability of productive factors (inputs) and
technology. It does not depend on the price level.
AS Formula + Graph Explanation
Aggregate Supply (AS): Y = A × F(K, L)
In the long run, output is at its natural level (YN). The unemployment rate at YN is called the natural
rate of unemployment (un) and varies across countries.
Thus, the long-run AS curve (LRAS) is vertical, aligned with the natural level of output (YN).
Shifts in aggregate supply (Long run Aggregate Supply)
LRAS shifts with changes in the productivity of the economy, caused by:
- Technological innovation
- Increases in capital (K)
- Improvements in education (better labor quality)
- Better production organization (higher productivity)
- Improved institutional quality
Short- and Medium-Run AS (SRAS)
In the short term, firms must sell what they produce at existing price levels (prices are sticky). Thus,
SRAS is sometimes shown as horizontal.
However, because some firms can raise prices and others cannot, SRAS has a positive slope in reality.
Shifts in SRAS
- Rightward shift (↑ AS): Technological innovation, for example, increases short-term
aggregate supply. - Leftward shift (↓ AS): Rising expected prices lead workers to demand higher wages,
increasing production costs and reducing short-term aggregate supply.
Demand-side Policies Example 1: Expansionary Monetary Policy
- Graph:
We have the AD curve downwards, the SRAS curve upwards and the LRAS curve straight, in the intersection between AD and SRAS. - Short-term effect:
AD curve shifts rightwards = Prices and Output (Yn) increase
(Intersection between SRAS and AD1)
Explanation of the short term effect:
The central bank increases Money supply (Ms), as a result interest rates decrease so it is cheaper to invest. Result: AD increases, there is more production which is unsustainable, thus prices go up too.
- Long-term effect:
AD curve shifts rightwards, SRAS curve shifts leftwards. We have a new additional equilibrium which is the intersection between the three lines.
Explanation of Long-term:
It is called prices of automatic adjustment.
Businesses can’t sustain this level of production, so supply reduces until Y2 = Y0 = Yn
Because price expectations go up, employees ask for higher salaries and businesses adjust their prices.
Conclusion: The effect on production disappears Y2=Y0. Only price level changes.
Demand-side Policies Example 2: Expansionary Fiscal Policy
- Short-term
We have the same graph as before. AD curve shifts rightwards: P increases Y increases.
- Long-term
Process of automatic adjustment. (Same graph as before).
Employee expect higher salaries, costs go up, SRAS shifts until Yn=Y2
Conclusion:
- Demand side policies will never have a real effect over GDP, because of the automatic process of adjustment.
Final production will be Yn, only prices will go up. (In the short term they do have an effect)
Supply-side policies
In the long run, only supply-side policies can increase aggregate output, as they shift the natural
level of production.
Such policies aim to improve productivity across the economy.
Conclusion: Supply side policies do have a real effect over GDP and economic growth.
